OREANDA-NEWS. Gazprom faces commercial and funding challenges following the decision to push ahead with the Nord Stream gas pipeline expansion, Fitch Ratings says. These could hamper the project's implementation and significantly increase Gazprom's leverage if it had to raise funding for the project directly. However, the impact from additional debt would be unlikely to affect Gazprom's 'BBB-' rating, because the rating is capped at the same level as Russia. Without the cap Gazprom's rating would probably be in the mid 'A' category, reflecting its position as the major natural gas exporter to Europe and its presently very strong balance sheet.

The expansion, known as Nord Stream II, will double the existing pipeline capacity to 110 billion cubic meters (bcm). It is intended to help Gazprom reduce reliance on Ukraine, which still accounts for nearly half of Russian gas transit to the key European market.

But over the last couple of years Nord Stream I has been operating at only around 55% capacity because European authorities have restricted Gazprom's usage of the OPAL pipeline, which carries Nord Stream's gas on into Germany. A solution to this limitation, imposed to ease third-party access to the pipeline, would be necessary if the Nord Stream II's 55bcm capacity is to be fully used. Concurrently, Gazprom is negotiating the 63bcm capacity Turkish Stream pipeline with the Turkish authorities, but we understand that the parties are far from an agreement on terms.

The projects are also being planned at a time of soft European demand and sharply lower gas prices. Gazprom's European gas sales fell 7% yoy in 1H15 to 80bcm, while its average European gas prices declined by 26%, hitting multi-year lows. While we expect that in 2015-2016 Gazprom's European gas sales volumes will be broadly steady, we forecast its gas prices in Europe will fall another 15% from current levels.

The original Nord Stream was funded by project finance. But despite a generally favourable funding environment for project finance and a strong shareholder base including several of Europe's top gas producers and off-takers, we believe raising multi-billion dollar project financing for Nord Stream II in the capital markets would probably be much harder now. This is because Western sanctions have significantly hindered international funding to Russian corporates, even those not directly sanctioned.

Weak gas prices and demand, plus high capex mean Gazprom would not be able to fund its share of capex (51% of an estimated EUR10bn) from internally generated funds. If project financing were not available it could therefore have to try and borrow directly to fund its share of pipeline projects' costs, but this too would be difficult and potentially expensive in the current funding environment.

Even before considering Nord Stream II and Turkish Stream capex, we expect Gazprom to generate negative free cash flows of USD3bn per year in 2015-2018 after capex and dividends. If the company issued debt to cover all its share of capex for Nord Stream II and Turkish Stream, its FFO net adjusted leverage could increase to 1.7x in 2017, from 1.1x at end-2014. This would still be below the 2.5x guidance level that we see as appropriate for its rating.

Gazprom signed the shareholder agreement on the Nord Stream expansion with Royal Dutch Shell, E.ON, OMV and Wintershall earlier this month. Gazprom, Wintershall and E. ON are shareholders in the existing 55 bcm capacity Nord Stream Lines 1 and 2 commissioned in November 2011 and October 2012.